ByJim Fuchs , Timothy A. Bosch
Bank closings are now front-page news in many small communities, with 81 occurring so far this year (as of Aug. 21). Even small towns like Winchester, Ill. (population: 1,650), have experienced the transition of a failed bank to new ownership.
Although today's challenges are great, the four underlying reasons for bank failures have not changed from those of years' past, which are:
The imbalance of risk versus return can best be illustrated through example. In 2008, ANB Financial N.A., Rogers, Ark., failed. (See www.treas.gov/inspector-general/audit-reports/2009/oig09013.pdf.) Public data show that in less than a two-year period, ANB went from being a mid-sized community bank with $600 million in total assets to a $2.2 billion institution. The bank's balance sheet showed that most of the growth into the risky construction and land development (CLD) loan segment was funded through brokered deposits.
On the surface, ANB's loan pricing of the construction and land development loans appeared favorable. Loans were often priced 300 basis points above typical real estate rates. While 300 basis points seemed opportunistic at the time, the rate charged was insufficient for the risk being assumed. A substantially higher premium, perhaps an unimaginable risk premium, would have been necessary to compensate for the lower quality asset.
ANB is an extreme situation. Nonetheless, during strong economic times, the pricing of balance sheet assets is frequently misaligned with the inherent risk acceptance in lending. The result is felt when economic tides turn and losses are experienced.
Failure to diversify can occur on both the asset and liability side of the balance sheet. Any concentration of assets by loan category, industry or geography creates the potential for material losses when stress events occur. Choosing not to diversify intensifies the need for higher capital ratios.
Diversification needs to occur on the liability side of the balance sheet as well. More than 85 percent of ANB's funding came from brokered deposits. Brokered deposits, while relatively inexpensive, created huge liquidity consequences when the bank's financial condition deteriorated. Prompt corrective action guidelines restricted the renewal of brokered deposits and limited the rates that could be paid on all deposits. In short, ANB experienced an old problem: Liquidity is unavailable when it is needed most.
A major contributor to today's financial crisis was the failure to fully understand the products in the financial marketplace and their counterparty risks. Even community banks purchased structured products, such as mortgage-backed securities, presumably designed to lessen balance sheet risk. Banks purchasing the product frequently did not fully understand the composition and risks of the underlying assets, and instead relied on rating agencies or product brokers for the analysis.
Risk management can be a difficult topic for community bankers who often don't have sophisticated systems in place. In some respects, though, good risk management is simply good management. Good management involves a culture of understanding risks in the institution's operations and how those risks change as product structures evolve, business operations transform, or economic conditions cycle. Good management involves an environment of strong internal controls and high ethical standards on the part of every employee. Good management requires an effort to properly align incentives with performance and to develop appropriate checks and balances through internal audit and board of directors' oversight.
As bank failures are reported over the next few years, each will have its story. Inevitably, the story will reflect one of the themes discussed in this article. Banks that avoid the risk factors will emerge as the survivors in an industry that will end up stronger.
Listen as Tim Bosch discusses how banks can avoid failure